Newsletter: Correction Not Crisis

Welcome to the second of our series of financial newsletters of a different kind, supplementary to our Tax Tips & News, designed to keep you informed.

The focus here is firmly on the big economic events of the day, representing part of our central ethos of working with you and developing the close working relationship that we strive to deliver. It is still relatively early in the New Year with the final self-assessment deadline out of the way and at Vincent & Co, we believe it is the perfect time to think about reviewing your financial situation – both on a personal level and for your business.

Last Autumn, we recognised fears for the global economy had intensified somewhat and since the epicentre of trouble is not one of Europe’s smallest economies but China, one of the world’s biggest, it is the potential impact that is much greater. Reality has shown that as winter did eventually arrive, it has coincided witha dismal start to the year for global stock markets. Yes, slowing growth in China is the major contributory factor but the continuing collapse in oil prices and talk of a bear market in shares are all contributing to the current scenario. Commodity prices continue to tumble – crude oil prices fell to below $30 a barrel for the first time in nearly 12 years but has bounced back a little. At times, share priceshave followed oil downwards. That is to be expected for the shares of companies in the oil business but for others it reduces costs and leaves consumers with more to spend on their products.

So what is going on? Do these financial market developments in the immediate term tell us anything about the state of the global economy? Furthermore, market turmoil: how does it affect us? Let us firstly revisit some core principles for those of you with investments:

Long-term investment is, typically, the best way to create and grow wealth for investors. Stock markets can be fairly predictable over long periods of time but, in the short term, markets can be prone to short term bouts of volatility.

Let’s look at China. The fundamental forces are not new. There is the slowdown in emerging economies’ growth. China is the outstanding example but certainly not the only one. It was, however, the Chinese market where the instability began, and spread around the world.

In itself, the Chinese stock market is not the fundamental international problem. Yes, it is a serious problem for those Chinese investors who bought shares when prices were high. They have lost a great deal of money but there are too few of them for it to have a likely dramatic impact on consumer spending in China and there are too few foreign investors in the Chinese market for there to be serious losses inflicted outside the country as a direct consequence.

It’s not just the stock market. The currency, the yuan, has also been under pressure. It has also lost ground this year, though not on the scale of the stock market. It is in part a sign of Chinese savers wanting to get their money out, wondering what sort of return they will get in China. There is also a concern that if they delay, the currency will fall further and they will get less for their money.

These financial market pressures on China are in part at least a symptom of the wider and much discussed economic slowdown.

Ever since China’s economy began to lose some pace, there has been uncertainty about how well the authorities would manage the process.

Certainly China needed to slow to a more sustainable pace. But would the path be a rocky one, with too abrupt a slowdown?

So far, the official figures suggest a significant but not catastrophic slowdown in growth. After three decades of 10% average growth, China slowed to 6.9% last year, according to the official figures just published.

Certainly these figures are viewed with extreme scepticism by some, but not all. The Economist said last month in anticipation of a 2015 figure of close to 7% “that figure may be an overestimate but it is not entirely divorced from reality”.

What is clear is that it is substantially slower than it was just five or six years ago.

“Overallgrowth in China is evolving broadly as envisaged but with a faster-than-expected slowdown in imports and exports, in part reflecting weaker investment and manufacturing activity. These developments, together with market concerns about the future performance of the Chinese economy, are having spillovers to other economies through trade channels and weaker commodity prices, as well as through diminishing confidence and increasing volatility in financial markets. Manufacturing activity and trade remain weak globally, reflecting not only developments in China, but also subdued global demand and investment more broadly—notably a decline in investment in extractive industries. In addition, the dramatic decline in imports in a number of emerging market and developing economies in economic distress is also weighing heavily on global trade.”

Now it is true that all those trends are widely seen as necessary, inevitable and even desirable. China’s investment levels are very high and could not be sustained.

It has been widely expected that the economy would shift towards services with less emphasis on manufacturing. Service industries mean more emphasis on Chinese consumers, less on exports and less need for imports of industrial raw materials.

The unnerving bit in the IMF comment is the “faster than expected”. The market wobbles of recent weeks are not driven by the IMF report but they are partly about whether the slowdown might be a crash rather than a gentle deceleration.

Furthermore, the jitters about the economic outlook are not just over China. The IMF’s new forecast downgrades the outlook for the emerging and developing countries. The ones that stand out are Russia and Brazil. That’s partly about the low prices of oil and other commodities as well as political problems, external for Russia, domestic for Brazil.

In summary, then, the broad picture from the new IMF forecast is for a modest acceleration in global economic growth this year and a little more in 2017 but there are also risks and they are bothering the markets. , However, we think pessimism in the markets may have been overdone. For instance, the global economy is growing around 3% and whilst China’s economy – which is the focus of so much of the recent sell-offs – has slowed, there’s still growth, strong consumption, and indeed the world’s second-largest economy does look relatively stable.

THE OIL PRICE SLIDE

What are the main reasons behind the fall in prices?

In a nutshell, it’s down to too much supply and too little demand.

China’s economic slowdown has curbed appetite for commodities in general, while Saudi Arabia, which produces a third of the Opec cartel’s output, is keener on preserving its market share than it is on cutting production to boost prices.

At the same time, the rise of the US as a shale oil producer means it now imports less oil, adding to the glut on world markets.

This makes life harder for other non-US, non-Opec producers, who are facing cutbacks, particularly in the North Sea.

Improved relations with Iran – Iran’s re-entry into the market mean supply is high and likely to stay high

What does all this mean to me?

It means lower petrol prices, although what we pay at the pump does not fully reflect the oil price drop. Bear in mind that excise duty and VAT make up nearly 60% of the price of a litre, and that isn’t coming down any time soon.

Obviously if people are spending less at the forecourt, they have more money to allocate elsewhere, and that is a potential boost to the economy.

However, if petrol-driven cars cost less to run, that means there’s less incentive to invest in alternatives, such as electric vehicles, so in the long run, low petrol prices could be bad for the environment.

What’s an oil producer to do amid tumbling prices?

Ask everybody in the business to cooperate, it seems but if you’re Opec, that means asking non-members, such as Russia to join in with curbing production and it must be said that the prospects of any co-operation from outside Opec are weak at the best of times.

Furthermore, it has got harder in the last decade. The surge in US shale oil means it is much more difficult to manage the market without American co-operation, which would never be forthcoming. The US government wouldn’t want to work with Opec, and in any case private companies are the ones taking the decisions. They will only cut if it makes commercial sense to them and their shareholders. Who wants to lose market share in a highly competitive market?

Now we have the decision to lift sanctions against Iran – another aspect to the over supply problem – after the international nuclear watchdog, the IAEA, said Iran had complied with a deal designed to prevent it developing nuclear weapons. Iran has the fourth largest proven oil reserves in the world, according to the US Energy Information Agency and any additional oil would only add to the one million barrels a day of over-supply that has led to a more than 70% collapse in oil prices since the middle of 2014.

MARKET OUTLOOK

With our focus on you – the client – we now offer our independent view of the financial markets.

There are different views out there but we believe the market is still in the midst of a multiyear-long secular bull market but the coming year will hold one of several corrective phases that typically occur during bull markets.

Stocks are correcting because investors have become nervous about low commodity prices, growth slowdowns in China and Europe and eventually the prospect that there will be modestly higher interest rates in parts of the world.

The volatility in the markets will reflect economic news as it is released with investors eventuallypushing markets higher from current lows as they realise that the economy is neither too bad nor too good – this is the “economic Goldilocks” scenario of being neither too hot nor too cold.

In terms of portfolio construction, we believe investors should remain focused on growth now the markets are in their current corrective phase but shift to value in the second half of the year. We are closely monitoring those funds, which contain high-quality large-cap stocks, with strong cash flow, earnings consistency, and brand power. The combination of quality and value is key going forward. For instance, we like individual companies that are trying to adapt to the omnichannel world, where you can have something delivered, pick it up, or go to the store—whatever you want. Purely brick and mortar operations are now dinosaurs. Modern fund managers who share our view will gain our favour.

The last 12 months have been tough but it will be possible to achieve good results over the next 12 months despite the obvious challenges that lie ahead.

Generally positive economic news continues – inflation and unemployment low; GDP growth steady but not immune, as the authorities now warn, from external factors, such as the aforementioned slowdown in China and the troubles in the Eurozone, which have certainly not gone away.

EURO-AREA: CAUTIOUS

Europe still faces structural challenges, including high debt levels still and poor demographics. That said, the continent is coming out of the doldrums of the economic cycle despite significant variation between individual economies.

EMERGING MARKETS: SELECTIVE APPROACH; CAUTIOUS

It is important to remember that EMs are not all one market, so you can find opportunities even with weak commodities and a strong $. With recent price movements, many high-quality emerging-market stocks have become cheap. In China, companies that were trading P/Es – price relative to earnings – between 25 and 30 are now in the mid-teens. Valuations in Eastern Europe are trading at the low end of historical ranges. On the other hand, valuations in India are high – some Indian companies are among the highest-quality companies you can find in EMs. These companies have good earnings growth, strong management, and great returns on equity. Within emerging markets, we think it is best to avoiding commodities at the present time. Nevertheless, we believe that a cyclical emerging market recovery is not unrealistic despite the prevailing doom and gloom.

U.S – NEUTRAL; CONTINUED STRONG DOLLAR

As technology-enabled shale discoveries is a driving force to successfully extract oil and gas. As a result, U.S. oil production increased significantly starting in the second half of 2012—so much so that it had a meaningful impact on the U.S. current account deficit. Less than five years ago, the U.S. current account deficit, just from petroleum-based products, averaged around $30 billion a month. Today, that number is less than $10 billion a month and declining. This is a meaningful impact, and has been a significant tailwind for dollar strengthening.

The above is our opinion but it is no guarantee of future performance. The above information expresses an economic viewpoint, which should also not be solely relied upon for investment purposes. Where investments are concerned, we seek a balanced portfolio and reiterate the preference for putting in place a balanced portfolio of investments, made up of collective investments. As you are aware, there are many ways to invest in equities. Each has its own practical and taxation considerations and, for this purpose, collective investments, such as unit trusts, are an appropriate means by which a good spread of investments may be achieved. Such pooled funds put the fund in a position to hold a good spread of company shares. The funds are managed on a day-to-day basis by professional investment managers to try and achieve the best possible returns. They represent the best means of managing the risks by asset allocation. The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested. Past performance is not a guide to future returns. Current tax levels and reliefs may change. Depending on individual circumstances, this may affect investment returns.